HERITAGE FINANCIAL CORP quarterly report, Q1 FY2012

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Heritage Financial Corporation — Q1 2012 Form 10-Q

Period and business: Unaudited quarter ended March 31, 2012. Heritage is a Washington-based bank holding company operating Heritage Bank and Central Valley Bank, focused primarily on commercial lending and deposits in Washington and the greater Portland, Oregon area. Unless noted, figures below are in U.S. dollars; financial amounts are in millions.

Financial performance and condition

  • Profitability: Net income was $4.17 million, or $0.27 per diluted share, versus $0.76 million, or $0.05 per diluted share, in Q1 2011. Income before taxes was $6.11 million versus $1.05 million.
  • Revenue and margins: Net interest income rose 7.0% to $16.69 million. Total interest income was $17.99 million, up from $17.49 million, while non-interest income fell to $1.91 million from $2.91 million. Net interest margin improved to 5.35% from 5.08%; net interest spread rose to 5.20% from 4.88%. The efficiency ratio improved to 67.7% from 70.7%.
  • Credit costs: The provision for loan losses was a $109,000 net recovery (negative provision), versus $4.37 million of provision expense in Q1 2011. Originated-loan net recoveries were $246,000, compared with $3.28 million of net charge-offs a year earlier.
  • Expenses and taxes: Non-interest expense decreased 3.7% to $12.60 million, despite salaries and benefits increasing $561,000. Income tax expense was $1.94 million; the effective tax rate was 31.8%, versus 27.2%.
  • Cash flow: Operating cash flow was $5.91 million, compared with $2.91 million in Q1 2011. Cash and cash equivalents increased $16.00 million during the quarter to $139.76 million.
  • Balance sheet and liquidity: Total assets were $1.375 billion, up 0.4% from year-end 2011. Net loans were $990.89 million, down $13.59 million; deposits were $1.140 billion, up $3.49 million. Non-maturity deposits increased $18.69 million while certificates of deposit declined $15.20 million. Repurchase-agreement funding was $20.79 million, down from $23.09 million; the company reported no other borrowings outstanding. Cash was 10.2% of assets, and securities maturing within one year had a fair value of $31.0 million. Disclosed uncommitted facilities included $161.0 million with the FHLB, $70.1 million with the Federal Reserve Bank, and $42.8 million in federal-funds lines with other banks.
  • Capital: Stockholders’ equity was $205.66 million, or 15.0% of total assets, versus $202.52 million and 14.8% at year-end. At March 31, Heritage Bank and Central Valley Bank were reported as well capitalized; their Tier 1 leverage ratios were 12.8% and 10.4%, respectively.

Material changes and credit quality

  • Earnings increased substantially year over year, primarily reflecting higher net interest income, the sharp reduction in loan-loss provisions, and lower non-interest expense; lower FDIC indemnification income partly offset these gains.
  • Total loans receivable, including purchased loans, declined to $1.022 billion from $1.035 billion at year-end. Originated loans were nearly unchanged at $837.35 million. Commercial business represented 83.3% of originated loans.
  • Originated nonaccrual loans fell to $18.20 million from $23.34 million; nonperforming originated loans were 1.88% of originated loans, down from 2.57%. However, other real estate owned rose to $8.35 million from $4.48 million. The company transferred $4.31 million of loans to OREO during the quarter.
  • The allowance for originated loans was $22.56 million, or 2.69% of originated loans, and 143.11% of nonperforming originated loans after excluding government-guaranteed amounts. Potential problem originated loans increased to $31.27 million from $29.74 million. Performing originated TDRs rose to $14.61 million from $13.81 million.
  • The company recorded three defaults involving previously restructured commercial and industrial loans, totaling $360,000 in principal balance; the related allowance was $23,000. Management noted that some modifications involved extensions, interest-rate reductions, or longer amortization.

Outlook, commentary, and risks

  • No specific earnings or financial guidance was provided. Management described ongoing plans to expand commercial lending and market areas, while noting that growth strategies may keep expenses elevated until they generate longer-term results.
  • Management considered the originated-loan allowance appropriate but cautioned that economic deterioration, borrower or collateral changes, or regulatory review could require higher provisions and adversely affect earnings and capital.
  • Acquired Cowlitz and Pierce loan accounting remains a significant estimate-sensitive item. Better estimated cash flows on certain acquired-loan pools supported provision recapture in the quarter; lower future cash-flow estimates could produce additional provisions. FDIC loss-sharing and the related indemnification asset are also subject to estimates and amortization.
  • Other notable items included a $36,000 impairment charge on held-to-maturity private residential mortgage securities and a $301,000 other comprehensive loss, largely reflecting the change in fair value of available-for-sale securities. The company said the unrealized securities losses were generally considered temporary, while acknowledging valuation uncertainty.
  • Interest-rate risk is identified as a significant market risk; management reported no material change in exposure since year-end 2011 and said it did not maintain a trading account or engage in hedging activities. The filing highlights risks from credit and real-estate conditions, interest rates, regulation, fair-value estimates, litigation, technology and third-party providers.
  • The board declared a $0.06-per-share dividend in February and, after quarter-end, declared a $0.08-per-share dividend payable in May. The filing notes that bank regulators can restrict subsidiary-bank dividends to the parent. Pending legal proceedings were described as not expected, in aggregate, to materially affect results or financial condition.

Important facts for investors to verify

  1. Whether lower credit costs and net recoveries are sustainable, and how nonaccruals, potential problem loans, TDRs, and OREO develop after quarter-end.
  2. The assumptions behind acquired-loan expected cash flows, FDIC reimbursements, and the carrying value of the FDIC indemnification asset.
  3. Whether growth in commercial lending produces the anticipated revenue without a renewed rise in credit losses or operating costs.
  4. The availability and terms of the disclosed uncommitted liquidity facilities, and the continued stability and mix of deposits.
  5. Whether the banks maintain capital levels and dividend capacity under regulatory requirements and possible adverse credit or economic conditions.